Last month, Lord Turner, chairman of the Financial Services Authority, unveiled his long-awaited report on global financial regulation. Whether it can revolutionise the financial industry is yet to be seen, but without wishing to speak solely in superlatives, it does represent a massive change in the way the regulator, and eventually the whole market, views itself.

Rebecca Bond, global director, FRS Global

The new regime will hit the unprepared hard, but it signals only the first of many changes that will affect the financial sector in the coming months. The “if it ain’t broke, don’t fix it” model for regulation still holds some credence, but when it comes to liquidity, something is certainly broken. The market can no longer assume that tail events are isolated incidents and this requires a real shift in risk policy.

To analyse the entirety of the Turner Review would take time, but focusing on the thorny issue of liquidity is an effective way of looking at the industry. The FSA introduced a consultation paper on “strengthening liquidity standards” in December 2008. Perhaps unsurprisingly, given its timing, it slipped under many people’s radar, despite wide-reaching implications for financial institutions.

However, with the consultation process closed and the new regime taking effect in October, banks must act quickly to get their houses in order. This will be no mean feat given the proposal heralds a big change in the way liquidity risk is to be managed, and against the backdrop of a regulator recently unafraid of stepping centre stage.

Back to Turner, the industry has voiced concerns over the practicality of some of the proposals. For instance, the potential tightrope of “balancing liquidity versus stability concerns”, in other words, ensuring that individual firms strengthening their individual liquidity positions do not make the whole financial system less stable. If the crisis has taught us anything, it is the fact that the industry is interconnected.

The Turner Review further extends the prospective regulation for liquidity with the introduction of a “core funding ratio”. This would impose limits on the amount of lending an institution could make based on the amount and quality of funding and serve to inhibit lending in times of high credit demand. It is also very much a macro-economic tool, effectively capping the amount of lending available for the whole financial system.

The FSA liquidity paper and the Turner Review make it clear that the regulator means business. They both highlight an overt and ambitious attempt to embed liquidity risk and its management into the everyday processes used to manage a financial institution. FSA chief executive Hector Sants’ comments before the liquidity consultation paper came out should have served to highlight the intent: “We do want to have a somewhat intrusive approach to regulation.”

However, Turner places far greater emphasis on the importance of addressing systemic risk, far beyond the consultation paper’s focus on individual institutions. This raises an interesting debate on risk and how, in general, it is best dealt with within an organisation that specialises in the management of that specific risk. After all, it was the transformation of credit risk into market risk that allowed those without the necessary expertise to acquire large amounts of credit risk. In future, the regulator may wish to consider not only if risk has been mis-priced but also misplaced.

Overall, the FSA seems in no mood to compromise. This is hardly surprising as regulators around the world continue to face criticism for their role in the financial crisis. It has been accepted that this will increase costs for regulated firms, and that some may need to consider their overall business model.

However, the regulator believes that this is a cost that the industry can and must bear. Then again, with so many changes and so many consequences unidentifiable, we may need to ask at what point the illness is better than the medicine.